My original thinking from Oct ’09 was, while I didn’t (and still
don’t) have a crystal ball I worried that: consumers were
over-stretched with debt (and make up 77% of the economy),
unemployment would continue to rise, which in turn would drive
the stock market south and cut the rate of M&A activity and
VC investment even further.

Sounds obvious now, but as I wrote the original piece the DJIA
had already come roaring back from 6,600 to 9,865 so it was
certainly against conventional wisdom. It eventually closed at
11,204 in April ’10 before sliding back around 10,000 as I sit
here and type. Well before the recent decline I sent out a
Tweet that said, “Many will disagree but I still fear deflation,
structural unemployment and political malaise.” Scott Austin of the WSJ
(worth following) saw my Tweet and asked me to go on record with
my rationale.

So I agreed to offer my current thinking on the economy and what
it portends for the VC industry & fund raising for
entrepreneurs.

Let me preface by saying I obviously have a vested interest in
being wrong about tough times ahead but as the old saying goes,
“hope for best, plan for the worst.”

• 2010 has been a
great year for startup fund raising: Let’s face it, 2010
has been “the year of the super angel / seed funds” that was
arguably first popularized by First Round Capital but has
gathered steam with the success of great firms like
Floodgate, Founder Collective, SoftTech VC and more recently
Felicis Ventures, 500 Startups and incubators like YCombinator
& Betaworks. The prices of angel deals have recently
crept up, VCs have also gotten their checkbooks out again, frothy
deals are happening and people are feeling bullish. I heard
an entrepreneur last Friday tell me that after he appeared on
AngelList he had a funding frenzy with one investor whom he had
never met offering to fund him after just 15 minutes on the
phone.
• We’re still caught
in the “post recession bounce”: What’s happening is that
the angel & VC community is still feeling good from having
bounced back from the nadir of the famous
“RIP Good Times” funk that we felt in 2008. This has been
especially true for angels or seed investors as there is a new
thesis that less capital is needed to start Internet companies so
more money is being spent at this phase of the funding lifecycle.
VCs have also gone back to writing checks because as an industry
we can’t be seen as “sitting on the sidelines” for years at a
time. VCs get paid to “put money to work.” While not 1999
all over again but I am observing first-hand the signs of funding
frenzy. I know not everybody agrees. Let’s talk again
in a year or two. I’ll happily eat crow if it turns out
this wasn’t an overly bullish phase. The industry is still
in major contraction with many funds shutting down or slimming
down and I believe this
trend will continue for the next few years.
• We have structural
employment issues: The official unemployment rate
in the US is hovering just below 10% but “true” unemployment is
much higher when you account for those that have stopped looking
or taken part-time employment and in key states like California
and Michigan we’re downright hurting. 45% of all unemployed
people have been looking for jobs 6 months or more – this is
unprecedented. And when you further strip out any
employment created by government stimulus that is uncertain to
continue going forward we know that the country is not creating
enough jobs. We’d have to hit 2.5% GDP growth just to stand
still on employment! And last quarter we now know grew at just
1.6%.

We as a country are suffering from what is known as “structural unemployment” where jobs have
disappeared from certain segments forever due to technological or
structural obsolescence. This led to the unusual
protectionist proclamations by Andy Grove (former CEO of Intel)
in a recent BusinessWeek article where he measures the US against
China in what he calls
the 10x problem – for every high-tech job we create in the
US, China is creating 10 as evidenced by Apple’s 25,000 employees
against its Chinese supply-chain of 250,000 (see Foxconn’s growth
below: now larger than HP, Microsoft, Dell, Apple, Intel and Sony
combined!).

Yes, I studied Ricardo’s theory of Comparative
Advantage in college that says that lower skilled jobs should
move to countries with lower labor costs, but Andy Grove’s point
about loss of skills in manufacturing leading to a decline in
innovation in the next technology wave is both real and
troubling. Here talking about lithium-ion batteries and the
early lead we’ve squandered in that market:

“With some technologies, both scaling and innovation take
place overseas. Such is the case with advanced batteries. It has
taken years and many false starts, but finally we are about to
witness mass-produced electric cars and trucks. They all rely on
lithium-ion batteries. What microprocessors are to computing,
batteries are to electric vehicles… The U.S. lost its lead in
batteries 30 years ago when it stopped making consumer
electronics devices… U.S. companies did not participate in the
first phase and consequently were not in the running for all that
followed. I doubt they will ever catch up.”

I don’t agree with his protectionist solutions such as tariffs,
but the problem seems both real and lasting.

• Personal balance
sheets are still stretched: The problem in the US starts
& ends with “consumerism” that was fueled by artificially
high real estate prices, which drove up spending and the stock
market. The reality is that we’ve spent beyond our means
for years and the process of “de-leveraging” (increasing savings
by spending less) has begun. We took $2.3 trillion out of
our homes and spent 2/3rds of it on flat screen TVs, trips to
Hawaii, time shares, Apple products and everything else we
couldn’t afford. The spending contraction is inevitable in
a period of declining real prices of housing, high unemployment
and tightening credit

High unemployment, wage stagnation, lowering real estate prices
and the lowering of demand for products may lead to deflation
(where prices of goods & services decrease each month – i.e.
the opposite of inflation). This coupled with government
intervention of companies “too big to fail” were the blight that
led to Japan’s “lost
decade.” Sound familiar? Deflation is crippling because
as consumers expect products to be cheaper tomorrow they hold off
purchasing every month to see what happens leading to a negative
spiraling economy.

The housing market is not recovered:
Sales in existing homes in the US fell 27.2% between June
and July 2010 (and 25% from a year ago). Sales fell in
every region of the country with the Midwest suffering the
worst at 35%. We also have an overhang of foreclosures
either held by banks or consumers who have not yet “blown up”
but are
increasingly behind on payments. Anybody
wanting to understand how “oversold” the housing market is
should read
The Big Short.

Government programs led to the law of “unintended
consequences”: Our housing slump now is continuing
well beyond where many people had hoped it would be by now.
Some of the delay is just overhang of a bad market but
we may be delaying true supply/demand matching through the
well-intentioned government’s attempt to stem price
declines. The government had a tax incentive for
first-time buyers that expired April 30th, which many people
believe “pulled forward” demand rather than improved the
market. The same happened in autos and one could argue that
the same has happened with the government stimulus
overall. Surely any retrenchment in Keynesian stimulus
will lead to further economic declines going forward. The
reality is that when governments try to intercede they often
create “the law of unintended consequences” and to a certain
degree assets prices just need to normalize.

Washington is in no mood to take stimulatory action –
for a long time: While there was a momentary unity
in the US government for bailouts & stimulus spending
that were initiated in the Bush administration (many people
conveniently forget this now) and continued under Obama, it
is clear that this era of consensus is over. Keynesians
will argue that this is a bad thing and fiscal conservatives
will argue that it is a necessary discipline. Either
way, the gridlock that is now the US congress will prevent
any real economic responses and it seems likely that this
political malaise will last beyond the 2012 election as the
Republicans look to make big gains in the 2010 mid-term
elections.

The Fed: That leaves the most likely
response to any economic weakening to be dealt with by the much
less political Federal Reserve. With interest rates near 0% the
Fed can’t cut interest rates to try and stimulate the economy
and drive good inflation (or avoid deflation). They would
need to turn to non-conventional means to spur the economy such
as
“quantitative easing.” In fact, just last week Fed
chair Ben Bernanke hinted that they would consider
“unconventional measures” during his speech in Jackson Hole
where he talked openly about the problems in the US economy:

“Consumer spending may continue to grow relatively slowly
in the near term as households focus on repairing their balance
sheets. I expect the economy to continue to expand in the
second half of this year, albeit at a relatively modest
pace.”

While he is publicly saying that he expects a
modestly improved economy in 2011, it’s hard to be too
sanguine when you look at the data. Consumer debt relative
to incomes has risen to an all time high reaching 138% of 2007
(obviously that’s not sustainable!) and has recently come back
down to 122% (said David Brooks on The PBS News Hour).
Historic averages were in the mid-60′s. It’s obvious
that consumers need to cut back spending.

Bernanke again:

“the pace of spending will … depend on the progress that
households make in repairing their financial positions. Among
the most notable results to emerge from the recent revision of
the U.S. national income data is that, in recent quarters,
household saving has been higher than we thought”

Obviously a “good news, bad news situation.” People are
lessening their debts but that decrease in spending slows the
economy. I expect this to continue. In the long run
it’s important but in the short-run I expect more volatility in
the market. As I like to say, “We were at one hell of a
25-year cocktail party, expect that the hang-over is just going
to take some time.”

State & local governments are going to be
hit: One likely result of the economic crisis
and lack of political alignment in Washington is further
cut-backs at state and local levels because unlike the federal
government they can’t print money. This spells further
unemployment, cuts in services and a further retrenchment in
middle-class spending and housing prices. In California the
primary school education system has cut 10 days from the school
year to save jobs. Surely cut-backs are needed in every
state but we’re going to have a heck of a debate going on about
where to cut. But as you can see from the graph below
while private sector jobs in CA have contracted the public
sector job rate has been static. I doubt this situation
will hold politically. Oh, and one more politically
charged issue we’ll deal with in our lifetime – the total
“pension shortfall” across all states in the US is estimated at
more than $1 trillion dollars.

And the tax changes for 2011 could cause a further
end-of-year sell-off: Another factor often not
discussed is that the
capital gains tax increases coming into effect in 2011 are
might just lead to a stock market sell-off in Q410 as investors
“lock in” gains at a lower tax rate. Stock market declines
equal lowering of wealth effects which in turn equals lower
consumer spending and hits on corporate earnings.
This affects M&A activities for startups, which with the
reduction of the IPO market could spell lower returns in the
short-term for technology startup investors. I try not to
predict stock market prices are too much because I’ve lost
track of what “normal” is. I just checked and if you
bought $1,000 of the S&P Index exactly 10 years ago it
would be worth $700.64 today (and that excludes the effects of
inflation). But at a minimum it’s hard for me to sign up
to a “bullish” stock market scenario. I’ve heard them
argued – I’m a bit circumspect.

The initial vulnerability will affect angel
investors: The stock market and real estate
impacts usually hit angel investors (excluding angel funds)
before they hit VCs so that is where the initial hit will
likely come again this time. This class of investors is
more diversified across categories plus is investing personal
money and therefore feels the hit in assets declines
first. Also, if there is a lowering of M&A activity
this will lead to increased financing needs for startups
driving higher failure rates or increases in “adverse terms”
entering future financing rounds. Either won’t bode well
for angels if they’re also hurting on non tech investments.

Many entrepreneurs could be caught in the “series
A&B funding gap” Equally worrying for
entrepreneurs if the markets take a turn for the worse is that
even if they managed to get angel rounds funded they may run
into a VC brick wall. VC funding is definitely back from
the constipation that was 2009 replete with frothy valuations
chasing dreams of the next Facebook, Groupon or Zynga.
But a double-dip recession couple with
contracting VC market highlighted by Paul Kedrosky, a
Kauffman Fellow, will surely bring back a period of inertia.

What does this mean if you’re an investor?

If we do have a double-dip recession or a “lost decade” the
investors who have put money to work in capital efficient
companies at reasonable (not frothy) valuations will fare the
best.

The investors who in my opinion will be especially vulnerable are
those who chose to spread too many bets or didn’t reserve enough
for follow-on investments. Massive market corrections
require hands-on investors who are good at: building management
confidence in tough times, encouraging costs cuts, performing
triage so that the strongest survive and helping shepherd
co-investors into writing follow-on checks. You simply
can’t do with with 50+ active investments for one person. I
saw this first hand in the first dot-com crash.

What does this mean if you’re an entrepreneur?

If economic times turns out to be worse than they are today
entrepreneurs who raised enough money in 2010 to weather a storm
will be best placed to survive the second dip or the long lack of
recovery. Additionally, those who run lean operations and
raised money from supportive investor bases will be best
positioned. Having a combination of entrepreneur-friendly
angels plus deep-pocketed VCs might be just what the doctor
ordered.

In the end

I’m a venture capital investor so I will still be looking to make
investments. My time horizon for investing is 7-10 years so
today’s economy doesn’t affect my exit prices BUT I need to be
sure the companies I invest in reach the promised land. I
will continue to look for “lean” teams, co-investors on deals to
help get through any rough patches and entrepreneurs who have the
resiliency to make it through whatever the economic conditions
throw at us.

The tech industry can help with job stimulation, but we’re not
immune to macroeconomic trends.